Which Lever to Pull- Monetary or Fiscal?

“When the GDP growth increases, the government feels it is structural and when GDP growth falls, it feels it is cyclical.”

-Dr. Y.V. Reddy, former RBI governor at SBI Conclave, 2019

The above statement just becomes a good pick amidst the slowdown gloom for the reason that it highlights the classic blame game where our government is not really ready to acknowledge the slowdown. The severity of recent ‘quasi recession’ has gathered eyeballs of policymakers from all spheres and the very debate between it being structural or cyclical has opened the house for policy debate as well. As Dr. Y.V. Reddy said, the current slowdown appears to be a combination of structural and cyclical factors, I believe it is structural in large parts. This is so because its effects on unemployment, consumption, investment and other macroeconomic variables look more permanent and persistent, with no quick return to their long term trend positions. These structural changes cannot be easily offset by monetary and fiscal policies alone, and thus would require pulling either lever with great caution and good understanding of macroeconomics.

Whether or not a counter-cyclical government spending boost or an expansionary monetary policy is going to bring an uptick in growth, makes us question the existing monetary and fiscal policy frameworks. In my opinion, to a larger extent our new monetary policy framework with inflation targeting approach is to blame for what has resulted in too high real interest rates for a long time, thus affecting the private sector investment and domestic consumption. On the top of it, a weak monetary policy transmission mechanism offers no good way out through successive rate cuts but to only keep inflation within idealized bounds, neglecting growth. This calls for a rethinking of monetary policy with a focus on multiple targets and not inflation alone before this lever dies a slow death as it has been lately. Additionally, the Fiscal Responsibility and Budget Management (FRBM) act constraints the government for a combined fiscal deficit to be at 3% of GDP, although now aimed at 3.3% of GDP by 2020. Given this restriction, monetary policy will have to bear the burden as has been evident from recent successive rate cuts. The FRBM act can thus be made more nuanced in terms that the composition of fiscal deficit too be taken care of, with capital expenditure taking the lead. That would offer a rather plausible way to look at fiscal expenditures with due monitoring of prudent fiscal discipline per se.

The simplified bottom line is here. While slow growth with high inflation suggests supply side rigidities, slow growth with inflation below target suggests demand weakness. India is in the latter scenario wherein Indians are not spending on consumption goods by either saving with increased cash holdings, or maybe some don’t even have money to begin with. We need jobs and people on jobs at the same time to create buyers for the goods firms produce, and confidence in financial markets to channelize these workers’ savings into productive investment opportunities. This calls for the economy to rise as a whole and not in parts by launching an aggressive reforms package. That entails long due reforms in land, labour, capital markets and agriculture. Moreover, it’s time to up public spending on healthcare, education and skill development as these have high multiplier effects in the long run. Overall, India needs to address this holistically by pulling both the levers thoughtfully or we may soon be ‘off-stable path’ and not necessarily in a ‘disequilibrium’.